Classification shifting: impact of firm life cycle

Abstract

PurposeThis paper aims to examine whether firms in the decline stage of lifecycle manipulate core or operating income through misclassification of operating expenses as income-decreasing special items.Design/methodology/approachThe sample comprises of firms from an emerging market, India with data from 1996 to 2011. The paper uses the methodology given in McVay’s (2006) work and multiple regressions.FindingsManagers of Indian firms also engage in classification shifting, primary incentive being the desire to avoid reporting of operating losses. Furthermore, the use of classification shifting is dependent upon the stage of lifecycle in which firm is in. Specifically, firms in the decline stage of lifecycle are more likely to use classification shifting to avoid reporting of operating losses.Practical implicationsThe paper sheds light on a critical phase of the firm lifecycle, decline, which increases the possibility of the use of classification shifting, an earnings management technique which is tough to detect. Firms in decline, thus, may be trying to fool the investors who are infusing capital to save the company from going bankrupt; regulators, who are likely to focus less on troubled firms; and auditors, who may not be expecting core income manipulation in such firms.Originality/valueThe paper extends the literature on classification shifting and presents first evidence that such shifting is more likely to take place during the decline phase of firm lifecycle.